A microeconomic perspective on the “loans create deposits” meme

By Joseph Laliberté

A private bank’s “cash and cash equivalent” position as shown on its balance sheet typically includes its deposits with other banks, excess reserves at the central bank and vault cash.  In financial accounting, the cash flow statement illustrates the main elements impacting the cash and cash equivalent position of a business between the beginning and the end of a given period.

Perhaps one of the most fascinating aspect concerning the obsession of mainstream macro economists with banks’ cash and cash equivalent position (excess reserves, in particular) is the near irrelevant status this component has in banking and financial circles.  Below is an extract from a letter of the German Banks Association (Bankenverband) to the International Accounting Standards Board (IASB) that illustrates perfectly the lack of interest that many have in regard to banks’ cash position:

One of the major objectives of the boards' proposals is to provide information which is relevant to predicting future cash flows.  We agree that the issue of liquidity presents a significant challenge for the banking sector.  Nevertheless, cash flow statements cannot help to assess future liquidity in any way.  No financial analyst, for example, has ever queried any of our member banks about, or given any great consideration to, the cash flow statement.  If the IASB has information pointing in another direction, we would be interested in the details. (emphasis added)

Illustrative of the non-importance of a bank’s cash flow statement is that the very definition of “cash and cash equivalent” used for the purpose of building the cash flow statement appears far from standardized across the banking industry.  Some banks, such as Deutche Bank, divide “cash and cash equivalent” on the asset side of its balance sheet into “cash and due from banks” and “interest-earning deposits with banks”. However, for the purpose of its cash flow statement, Deutche Bank defines “cash and cash equivalent” as “cash and due from banks” PLUS “interest earning deposits with banks” MINUS “term deposits with banks”.  For its part, the French bank Société Générale presents on the asset side of its balance sheet two categories (i.e., “cash, due from central banks” and “due from banks”) while for the purpose of its cash flow statement it defines "cash and cash equivalent" as follows: (“cash, due from central banks” MINUS “due to central banks”) PLUS (“due from banks” MINUS “due to banks”).  Closer to home, ScotiaBank defines “cash and cash equivalent” as “cash and non-interest-bearing deposits with banks”, thereby excluding interest-bearing deposits with banks, while National Bank includes cash and all deposits with financial institutions.  Go figure!  One would assume that banks would find it necessary to settle on a common definition of “cash and cash equivalent”, especially since we are often told by the financial press and many economists that this asset component is so critical in analyzing banks’ capacity to extend loans.

That said, even if all banks would settle on a common definition of “cash and cash equivalent”, this asset category would still say very little about a bank’s liquidity.  The reason for this is that any given bank could have a cash and cash equivalent position of zero and still be considered highly liquid thanks to its holding of cash management bills/T-Bills/government bonds. 

Furthermore, the cash and cash equivalent position says nothing about a bank’s capital ratio, the critical element in determining a bank’s capacity to extend credit.  Banks’ capital is allocated to balance sheet expansion through loan and deposit creation, not banks’ cash or reserve position.  As per the cash flow statement of a deposit-taking institution, net additional loans to customers are considered a use of funds, and net additional deposits from customers are a source of funds.  Therefore, once a loan is granted and the customer’s checking account is marked up by the same amount, the cash and cash equivalent position of the bank is left unchanged.  From a microeconomic banking perspective, loans create their own source of funds, or stated differently, "loans create deposits".  Assets-liabilities duration mismatch (interest rate risk) is of course an important consideration, and this is where the discussion ties in with the central bank’s decision on interest rate.

One last point that deserves to be highlighted is that, although a bank’s "cash and cash equivalent" position generally says nothing about its capital position and, consequently, its regulated lending capability, an increase in this asset item may sometimes reflect improved liquidity.  This was arguably the case with QE1 when the Fed purchased mortgage-backed securities (MBS) by crediting private banks’ reserve account at the Fed.  Moreover, if one assumes that with QE1 the Fed engaged in fiscal policy by overpaying for MBS (relative to their market value), then it could be argued that QE1 may have also helped to improve banks’ capital position as well as their regulated lending capability.

In the case of Canada, a QE1 style program was put in place, but since reserves were “mopped up” with the issuance of Canadian government bonds, there was no impact on banks’ “cash and cash equivalent” position, a situation that led to an improvement in their liquidity position (as it did in the U.S).  As for the matter of bank capital, contrary to the U.S., there was no direct injection of public funds to recapitalize the banking sector in Canada.  However, just like what happened in other jurisdictions, accounting authorities proved accommodative.  Changes to the Canadian Institute of Chartered Accountants Handbook in October 2008 allowed banks to re-classify financial assets from “held-for-trading” to “held-to-maturity” under specific circumstances.  Use of this re-classification put some banks on stronger regulated capital footing than would have been the case otherwise.

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